Japanese Investors & Toxic CDOs

"Even sheep should have brains enough not to follow the wolf".

Joseph Goodfield (author)

Even following an apparent letter to investors sent out by GS, you just know that Japanese institutional investors including city banks, regionals, insurers and pension funds bought a ton of CDOs backed by toxic real estate assets in the 2006-2008 window.

CDOs were attractive investments. They promised juicy yields and in many cases a AAA rating or a famous AIG guarantee. Back in 2006 the Accounting Standards Board of Japan made noises about excluding AA and higher rated CDO tranches from mark-to-market accounting. This was underpinned by the then-new Basel II requirements that effectively removed CDOs from being counted as regulatory capital for many banks in Europe and Asia provided they were of a particular rating.

Add to that the fact that the overall decline in credit spreads contributed to buyers moving down the credit curve to pick-up yield and it is easy to see how these products exploded in interest increasing 76% in 2007 to reach Euro 101 billion of rated credit issuance.

Japanese city banks and brokers likely played a key role as distributors or co-distributors of much of the U.S. structured paper, and probably in the later stages, or just before the 2008 collapse of credit markets in general. Much has been made of Mizuho and it's fateful move into the business in 2008. They would have done so using their bond salesforce who would have had little to do selling no-yielding JGBs.

In fact, the 2004-07 period was also a time when intermediaries "sold" many of the big name fund of hedge fund products (some of which no longer exist e.g. Ivy), again for the attraction that many of these products had offering juicy equity-like returns with fixed income-like volatility.

Many institutional investors had a bogey of 8% which was tough to reach in a 4% investment environment. There were strong incentives to buy these derivatives. Moreover, the returns for bank distributors were astronomical, with the riskier tranches of CDOs getting 150 bps in fees against the 30-55 bps that were associated with higher grade structures. So there were clear incentives to move the riskier products too.

The real scale of the Japanese institutional investor appetite for toxic CDOs is very hard for anyone to define, although it might be the case that in the same way that they accounted for about 20-25% of global HFoF sales in 2006-07, they might have also accounted for a similar amount of global CDO business. That means, out of an estimated 4Q2007 global issuance of $47.5 billion, maybe just under $10 billion was bought up by Japanese institutional investors in that period alone.

Of course many of the banks had to suffer the embarrassment of realizing this as losses, while other pension funds simply buried these "mistakes" among their broader portfolio losses. At some time in the future the truth surrounding Japanese investor losses in these structures is sure to come to light. It always does. Mahalo.